Market snapshot

Tim Mortimer of Future Value Consultants looks at the pricing issues for structured products in different markets and provides his trade of the month

Tim Mortimer, Future Value Consulants

Notional issuance of structured products in the US slowed while the most popular structures remained the same in December as they have been since August 2009. During the past year, accelerated growth products generated more sales than reverse convertibles even though the latter saw far greater issuance volumes.

JP Morgan and General Electric were the preferred underlyings for reverse convertibles in December by notional, confirming their popularity over the pst year – General Electric attracted the most investment in reverse convertibles in 2009. Generally, the most popular reverse convertible were linked to larger, more well-known companies. Products offering the highest coupons were often linked to volatile stocks.

The top two issuers remained the same this month, with Barclays once more accumulating more than 30% of the notional.

Potential income products appear in the UK

Capital-at-risk annual kick-out products continued to lead the way at the end of last year in the UK retail market, followed by capital-at-risk growth and potential income products. While the capital-at-risk products topped the list for the final two months of 2009, potential income products replaced reverse convertibles in the top three.

The potential income structure emerged in late 2009 as investors opted for capital protection over the downside risk of reverse convertibles. Potential income products remain competitive with reverse convertibles in terms of income rates, though the ‘potential’ income payments are not guaranteed and tend to depend on the underlying asset’s performance at specified dates. There are many variations and the structure typically appeals to cautious investors seeking regular income who expect little or no market movement.

Investec issued almost half of all products to UK retail, and was the biggest provider of potential growth products. Barclays Bank issued 16% of the new products in December, while Morgan Stanley replaced Gilliat Financial Solutions in third place.

Trade of the month: interest rates

The focus of this section this month is interest rates, more specifically swap rates, constant maturity swap (CMS) rates, their use as underlyings and the effects of interest rates on structured products.

A swap is a contract between two parties, where typically one party agrees to pay a floating-rate coupon (Libor) and the other a fixed rate, the fair market value of which is the swap rate. The swap will have a fixed maturity and the value of the contract will fluctuate throughout the term in the same way as a traditional bond. If Libor increases, the value of the swap falls for the party receiving the fixed coupons; likewise, if Libor decreases, the value of the swap to that same party increases.

A CMS takes the value of swap rates of a given maturity on a periodic basis so that it represents a swap of a fixed tenor on the yield curve. For example, a daily 10-year CMS rate would equal the 10-year rate available on the market if you entered a 10-year swap on any day.

Money market rates are short-term rates only available for up to one year. Any published rates that extend further than this are derived from swap rates. Because swap rates are the simplest liquid interest rate instruments, they are most commonly used to derive discount factors which are used to construct models.

Rates are most commonly seen as underlyings for income structured products, two examples of which are looked at in more detail in the following pages. Rates are not as suited to growth products which more commonly use equities because equities are expected to grow over the longer term. Interest rates are mean reverting in the long term. In the US, products linked to rates are common. These products usually fall into one of two types, either linked to one rate with the income coupons dependent on whether or not a given rate stays within a defined range (such as the JP Morgan product), or a structure like that issued by HSBC, which is linked to two rates of different maturities and the payoff is a function of the difference between the two. Products linked to interest rates are popular in mainland Europe particularly in the institutional market. However, they are not common in the UK retail market.

Levels of interest rates affect not only the structures for which they are underlyings but also the pricing of all structured products. Interest rates are important to many structures, particularly those with any capital protection. The level of risk-free interest rates is a factor in determining which products appeal to investors and are therefore issued.

In the UK, there has been a rise in the percentage of income products in the retail market over the past two years, which has been assisted by the fact that the average of the five-year risk free rate for 2009 was lower than the average in any of the previous 10 years. The lack of decent rates available through traditional deposit accounts on the retail market may have attracted those investors looking for income and in turn been responsible for driving up the issuance of income structured products. However it is not the only factor and the table below illustrates not only this recent increase but also the rise and fall of precipice bonds in the early part of the last decade all when interest rates were relatively high.

Market snapshot PDF